“Fallacies, irrelevant facts, and myths” in banking

Four economists from Stanford University and the University of Bonn have published a study essentially claiming that banks are full of it when they complain that it’s too expensive for them to raise money mainly by selling stock, like most companies do, and instead they need to use Other People’s Money (i.e. debt).

The study is part of the debate over whether the Basel III capital regulations go far enough to prevent another financial markets meltdown as happened in 2007 and 2008.

Regulators at the Bank for International Settlements in Basel, Switzerland, establish international capital standards (“capital” is bank jargon for equity) for financial institutions, and in October 2010 they issued revised rules in response to the crisis. The new rules are being called Basel III, because they’re the third try at getting this right. Basel I was in 1988 and Basel II in 2004.

From the October 20, 2010, study, by Anat R. Admati, Peter M. DeMarzo and Paul Pfleiderer from Stanford University and Martin F. Hellwig from the University of Bonn, “Fallacies, Irrelevant Facts, and Myths in the Discussion of Capital Regulation: Why Bank Equity is not Expensive”:

There is a pervasive sense in discussions of bank capital regulation that “equity is expensive” and that equity requirements, while beneficial, also entail a cost. The arguments we examine, which represent many of those most often made in this context, are fallacious, irrelevant, or very weak. Our analysis leads us to conclude that significantly higher equity requirements entail large social benefits and minimal, if any, social costs. We list below some of the arguments made against high equity requirements and explain why they are either incorrect or unsupported.

Some common arguments made against significantly increasing equity requirements:

—Increased equity requirements would force banks to “set aside” or “hold in reserve” funds that can otherwise be used for lending. This argument confuses liquidity requirements and capital requirements. Capital requirements refer to how banks are funded and in particular the mix between debt and equity on the balance sheet of the banks. There is no sense in which capital is “set aside.” Liquidity requirements relate to the type of assets and asset mix banks must hold. Since they address different sides of the balance sheet, there is no immediate relation between liquidity requirements and capital requirements.

—Increased equity requirements would increase banks’ funding costs because equity requires a higher return than debt. This argument is fallacious, because the required return on equity, which includes a risk premium, must decline when more equity is used. Any argument or analysis that holds fixed the required return on equity when evaluating changes in equity capital requirements is fundamentally flawed.

—Increased equity requirements would lower the banks’ Return on Equity (ROE), and this means a loss in value. This argument is also fallacious. The expected ROE of a bank increases with leverage and would thus indeed decline if leverage is reduced. This change only compensates for the change in the risk borne by equity holders and does not mean that shareholder value is lost or gained. Shareholders willing to take additional risk can increase their average return by buying stock on margin.

—Increased equity requirements would increase banks’ funding costs because banks would not be able to borrow at the favorable rates created by tax shields and other subsidies. It is true that, through taxes and implicit guarantees, debt financing is subsidized and equity financing is effectively penalized. Policies that encourage high leverage are distorting and paradoxical, because high leverage is a source of systemic risk. The subsidies come from public funds. If some activities performed by banks are worthy of public support, subsidies should be given directly to those activities.

—Increased equity requirements would be costly since debt is necessary for providing “market discipline” to bank managers. While there are theoretical models that show that debt can sometimes play a disciplining role, arguments against increasing equity requirements that are based on this notion are very weak. First, high leverage actually creates many frictions. In particular, it creates incentives for banks to take excessive risk. Any purported benefits
produced by debt in disciplining managers must be measured against frictions created by debt. Second, the notion that debt plays a disciplining role is contradicted by the events of the last decade, which include both a dramatic increase in bank leverage (and risk) and the financial crisis itself. There is little or no evidence that banks’ debt holders provided any significant discipline during this period. Third, many models that are designed to attribute to
debt a positive disciplining role completely ignore the potential disciplining role that can be played by equity or through alternative governance mechanisms. Fourth, the supposed discipline provided by debt generally relies upon a fragile capital structure funded by short term debt that must be frequently renewed. Reduced fragility, which is a key goal of capital regulation, would be at odds with the functioning of this purported disciplining mechanism. Finally, one must ask if there are no less costly ways to solve governance problems.

—Increased equity requirements would force or cause banks to cut back on lending and/or other socially valuable activities. First, higher equity capital requirements do not mechanically limit banks’ activities, including lending, deposits taking and the issuance of liquid money-like securities. Banks can maintain all their existing assets and liabilities and reduce leverage through equity issuance and the expansion of their balance sheets. That said, because equity issuance improves the position of existing creditors, and may also be interpreted as a negative signal on the bank’s health, banks might privately prefer to pass up lending opportunities if they must fund them with equity. However, this “debt overhang” problem can be alleviated if regulators require undercapitalized banks to recapitalize quickly by restricting equity payouts and mandating new equity issuance. Once better capitalized, banks would make better lending and investment decisions, because they would have reduced incentives to take excessive risk and indeed would be less affected by distortions due to debt overhang.

—The fact that banks tend to fund themselves primarily with debt and have high levels of leverage implies that this is the optimal way to fund bank activities. It does not follow that just because financial institutions choose high leverage, this form of financing is privately or socially optimal. Instead, this observed behavior is the result of factors unrelated to social concerns, such as tax incentives and other subsidies, and to frictions associated with conflicts of interests and inability to commit in advance to certain investment and financing decisions.

Watching for the next bubble

From the editor

To understand the financial crisis of 2007-2008, and to prevent the next one, you must understand the repurchase market.

Consider This

The financial crisis was not caused by homeowners borrowing too much money. It was caused by giant financial institutions borrowing too much money, much of it from each other on the repurchase (repo) market. This matters, because we can't prevent the next crisis by fixing mortgages. We have to fix repos.

Quotes in the News

Financial panics are increasing in frequency. While they used to be driven by depositors lining up to get their money, nowadays, "the problem is that institutional creditors do the same thing in the repo market." -- John Maxfield, The Motley Fool, March 19, 2015.
*****
"The repo market, the largest short-term funding market ... still remains susceptible to asset fire sales and runs." -- Office of Financial Research, December 2014.
*****
Repo “is the most important plumbing of the financial system. If the industry cannot come up with a solution, there is some implicit suggestion the Fed would have to step in in a more direct way." -- Darrell Duffie, professor of finance at Stanford University, October 9, 2014.
*****
"Without repo, there is no leveraged positioning in financial markets; without leverage and the constant hypothecation there is nothing to maintain the stock market's exuberance." Repo markets provide "the glue that holds stock markets together." -- Tyler Durden, Zero Hedge, June 27, 2014.
*****
"The Repo market includes both the banking system and the shadow banking system, all in one place. It’s the overnight borrowing and lending market of the entire financial system." -- Scott E.D. Skyrm, May 21, 2014.
*****
"The potential for repo markets to act as a channel for financial instability in the event of (or perception of) financial distress at a large dealer remains .." -- Standard and Poor's, May 13, 2014.
*****
"Regulators and policymakers currently have no reliable, ongoing information on bilateral repo market activity." -- Financial Stability Oversight Council, May 7, 2014.
*****
"These runs were the primary engine of a financial crisis from which the United States and the global economy have yet to fully recover." -- Federal Reserve Chair Janet Yellen, April 15, 2014.
*****
"The banks remain dangerously interconnected and vulnerable to sudden runs because of their dependence on short-term, often overnight borrowing through the multitrillion-dollar repurchase agreement, or repo, market. -- Jennifer Taub, associate professor, Vermont Law School, April 4, 2014.
*****
"The 2007–2008 financial crisis was driven more by disruptions in the Securities Financing Transactions markets than by disruptions in the over-the-counter derivative markets." -- Federal Reserve Governor Daniel K. Tarullo, November 22, 2013.
*****
“The money market fund industry and the repo market is really the major fault line that goes right under Wall Street." -- Dennis Kelleher, CEO of Better Markets, Bankrate.com, July 24, 2013.
*****
Repo: "The silently beating heart of the market." -- Treasury Borrowing Advisory Committee, July 2013.
*****
Under Basel capital rules, "repos among financial institutions are treated as extremely low risk, even though excessive reliance on repo funding almost brought our system down. How dumb is that?" -- Sheila Bair, chair of the Systemic Risk Council and 2006-2011 Chair of the FDIC, June 9, 2013.
*****
"The trigger for the acute phase of the financial crisis was the rapid unwinding of large amounts of short-term wholesale funding that had been made available to highly leveraged and/or maturity-transforming financial firms." --Janet Yellen, Vice Chair Federal Reserve, June 2, 2013.
*****
"The repo market wasn’t just a part of the meltdown. It was the meltdown." --David Weidner, Wall Street Journal, May 29, 2013.
*****
"While regulated banks have faced far tighter oversight following the financial crisis, the shadow-banking market remains a source of potential instability. It is worth remembering that runs here, rather than traditional bank runs, were a cause of the crisis and led to seizures of credit markets." -- David Reilly, Wall Street Journal, February 19, 2013.
*****
"It is worth recalling that the trigger for the acute phase of the financial crisis was the rapid unwinding of large amounts of short-term funding that had been made available to firms not subject to consolidated prudential supervision." -- Daniel K. Tarullo, Federal Reserve Governor, February 14, 2013.
*****
"I don’t think we should be comfortable with a situation in which extensive maturity transformation continues to take place without the appropriate safeguards against runs and fire sales." -- William C. Dudley, President, Federal Reserve Bank of New York, February 1, 2013.
*****
"The global financial crisis that began in the United States in the summer of 2007 was triggered by a bank run, just like those of 1837, 1857, 1873, 1893, 1907, and 1933 ... and it has had devastating effects that continue today." -- Gary B Gorton, Yale University, "Misunderstanding Financial Crises," November 2012.
*****
"Currently, the drivers of systemic risk remain largely intact, and shadow banking appears poised to grow considerably, and dangerously, if it does not acquire the necessary market discipline to shape risk-taking activities." -- From "Understanding the Risks Inherent in Shadow Banking" by David Luttrell, Harvey Rosenblum, and Jackson Thies, Federal Reserve Bank of Dallas, November 2012.
*****
"The essence of shadow banking is to make loans, securitize them, sell the securities and insure them, and actively trade all the financial assets involved. In effect, traditional relationship banking is replaced by a collateralized market system with the repo market at its heart." --William R. White, Organisation for Economic Co-operation and Development, August 2012.
*****
"What was different about this crisis was that the institutional structure was different. It wasn't banks and depositors. It was broker-dealers and repo markets. It was money market funds and commercial paper ...," --Federal Reserve Chairman Ben Bernanke, March 27, 2012.
*****
"The Federal Reserve was forced to take extraordinary policy actions beginning in 2008 to counteract the effect of (tri-party repo) flaws and avert a collapse of confidence in this critical financing market. These structural weaknesses are unacceptable and must be eliminated." --Federal Reserve Bank of New York, February 15, 2012.
*****
"Despite the Dodd-Frank financial reform bill and its directive to address this issue, the problem of bank runs in the shadow system -- a key factor in the financial sector collapse -- has not yet been solved." --Mark Thoma, Professor of Economics, University of Oregon, February 13, 2012.
*****
"Repurchase agreements (repo) are the largest part of the 'shadow' banking system: a network of demand deposits that, despite its size, maturity, and general stability, remains vulnerable to investor panic." --Jeff Penney, senior advisor, McKinsey & Company, June 2011.
*****
"What happened in September 2008 was a kind of bank run. Creditors lost confidence in the ability of investment banks to redeem short-term loans, leading to a precipitous decline in lending in the repurchase agreements (repo) market." --Robert E. Lucas, Jr., Nancy L. Stokey, visiting scholars, Federal Reserve Bank of Minneapolis, May 2011.
*****
"The really interesting thing that happened in September 2008 was the worldwide panic in the banking system – financial institutions running on each other behind the scenes." –-David Warsh, economic journalist, Feb. 6, 2011.
*****
“As a scholar of the Great Depression, I honestly believe that September and October of 2008 was the worst financial crisis in global history, including the Great Depression …Out of maybe the 13 of the most important financial institutions in the United States, 12 were at risk of failure within a period of a week or two.” --Federal Reserve Chairman Ben Bernanke, Financial Crisis Inquiry Report, January 2011.
*****
"Since repo financing was the basis of most of the leveraged positions of the shadow banks, a large part of the run occurred in the repo market." --Viral V. Acharya and T. Sabri Öncü, professors, Stern School of Business, New York University, 2011.
*****
"Housing policies alone, however, would not have led to the near insolvency of many banks and to the credit-market freeze. The key to these effects was the excessive leverage that pervaded, and continues to pervade, the financial industry." --Anat R. Admati, Professor of Finance and Economics, Graduate School of Business, Stanford University. January 30, 2011.
*****
"Without some repo reform, we are at risk for another panic." --Gary B. Gorton, Professor of Management and Finance, Yale School of Management, November 16, 2010.
*****
"While it may be well and good for the Dodd-Frank Act to demand more oversight of mortgages and derivatives, that won’t stop the next run on repo if lenders panic over a different kind of collateral or hear a false rumor and panic for no reason at all." --About Repo, RepoWatch.
*****
The repurchase market is “the deepest, darkest least noticed part of the market’s plumbing.” --Bethany McLean and Joe Nocera, "All the Devils are Here," November 2010.
*****
“So far, all of this has gone largely unnoticed by the public, and that gives shadow banks the opportunity to make their case unopposed." --Mark Thoma, Professor of Economics, University of Oregon, September 28, 2010.
*****
"... the structure of the tri-party market is so closely entwined that it creates a contagion risk as bad as anything seen in the derivatives world." --Gillian Tett, U.S. managing editor, Financial Times, September 23, 2010.
*****
"The collapse in CDO valuations and the resulting inability to use CDOs as collateral for repo was a major, if not the major, cause of dealer illiquidity and insolvency which resulted in massive bailouts and backdoor subsidies." --Yves Smith, Naked Capitalism blog, August 20, 2010.
*****
"Repo has a flaw: It is vulnerable to panic, that is, 'depositors' may 'withdraw' their money at any time, forcing the system into massive deleveraging. We saw this over and over again with demand deposits in all of U.S. history prior to deposit insurance. This problem has not been addressed by the Dodd-Frank legislation. So, it could happen again. The next shock could be a sovereign default, a crash of some important market -- who knows what it might be?" --Gary B. Gorton, Professor of Management and Finance, Yale School of Management, August 14, 2010.
*****
"Leaving the repo market as it currently functions is not an alternative; if this market is not reformed and their participants not made to internatlize the liquidity risk, runs on the repo will occur in the future, potentially leading to systemic crises." --T. Sabri Öncü and Viral V. Acharya, professors, Stern School of Business, New York University, July 16, 2010.
*****
"It is disconcerting that that the Act is completely silent about how to reform one of the systemically most important corners of Wall Street: the repo market, whose size based on daily amount outstanding now surpasses the total GDP of China and Germany combined." --Viral V. Acharya and T. Sabri Öncü, professors, Stern School of Business, New York University, July 16, 2010.
*****
"... it is imperative for policymakers to assess whether shadow banks should have access to official backstops permanently, or be regulated out of existence." --Zoltan Pozsar, Tobias Adrian, Adam Ashcraft, Hayley Boesky, Federal Reserve Bank of New York, July 2010.
*****
“The potential for the tri-party repo market to cease functioning, with impacts to securities firms, money market mutual funds, major banks involved in payment and settlements globally, and even to the liquidity of the U.S. Treasury and Agency securities, has been cited by policy makers as a key concern behind aggressive interventions to contain the financial crisis.” --Task Force on Tri-Party Repo Infrastructure, May 17, 2010.
*****
"Banks should have learned by now it's dangerous to rely on overnight lending." --Allan Meltzer, Professor of Political Economy, Carnegie Mellon University, March 28, 2010.
*****
"This banking system ‐‐ repo based on securitization ‐‐ is a genuine banking system, as large as the traditional, regulated banking system. It is of critical importance to the economy." --Gary B. Gorton, Professor of Management and Finance, Yale School of Management, February 20, 2010.
*****
"I think we were primarily focused on the potential collapse of the short-term funding markets, particularly the overnight repo markets and tri-party repo markets, which would have created a contagion to many other firms."--Federal Reserve Chairman Ben Bernanke, November 17, 2009.
*****
"The best thing to do with the shattered Humpty-Dumpty of mortgage securitization would be to toss the broken pieces into the garbage." --Arnold Kling, Mercatus Center, George Mason University, September 28, 2009.
*****
"Given its size and importance, it is surprising that repo has such a low profile; for example, there is little discussion of it in the financial press." -- Moorad Choudhry, Head of Treasury, Europe Arab Bank plc, London, "The REPO Handbook," September 2009.
*****
“Our regulators allowed the proprietary trading departments at investment banks to become hedge funds in disguise, using the ‘repo’ system - one of the most extreme credit-granting systems ever devised. The amount of leverage was utterly awesome.” --Charles T. Munger, chairman Berkshire Hathaway Inc., Spring 2009.
*****
"Repo borrowing is now by far and away the most important form of short-term finance in modern financial markets.." -- Alistair Milne, Reader in Banking and Finance, City University, London, "The Fall of the House of Credit," March 2009.
*****
“This helps explain how a relatively small quantity of risky assets was able to undermine the confidence of investors and other market participants across a much broader range of assets and markets.” --Timothy Geithner, president, Federal Reserve Bank of New York, June 9, 2008.
*****
"Until recently, short-term repos had always been regarded as virtually risk-free instruments." Federal Reserve Board Chairman Ben Bernanke, May 13, 2008.
*****
"The repo market is as complex as it is crucial. It is built upon transactions that are highly interrelated. A collapse of one institution involved in repo transactions could start a chain reaction, putting at risk hundreds of billions of dollars and threatening the solvency of many additional institutions." --U.S. Senate report, 1983.
*****
"Because of this widespread use in very large amounts, it is important that the repo market be protected from unnecessary disruption." --Paul A. Volcker, Chairman, Federal Reserve Board, September 29, 1982,
*****
"With a repo loan, financial institutions could make or buy more home loans, to pool and produce more securities, to use as collateral for more repo loans. It was a neat, self-sustaining cycle of profitability and a serious growth machine." --About Repo, RepoWatch.
*****
"Surprisingly, financial institutions that said they used securitization to offload risk had actually done just the opposite. Instead, it was the repo lenders who had no skin in the game." --About Repo, RepoWatch.
*****
"Repo, then, was the main way that defaults in the housing market became a full blown credit panic. It was the key transmitter that carried the shock wave from the defaulting homeowner through the canyons of Wall Street to the American taxpayer." --About Repo, RepoWatch.
*****
"In the savings and loan days, we called it Cash for Trash. In those days, thrifts lent borrowers more money than they needed and required the borrower to use it to buy a troubled property on the thrift’s books. Today, banks make repo loans to borrowers who use the money to buy troubled mortgage securities on the banks’ books, and then they use the troubled securities to collateralize the original repo loan from the bank." --Inside Jobs, RepoWatch.
*****

New to Repo?

Start with "About Repo" in the header above.

What’s $1 trillion?

Spending at $1 a second, it would take you 31,710 years to spend $1 trillion. -- Repo is $7 trillion. (See "About RepoWatch.")

Breaking News

The Fed's reverse repo facility could help stabilize the repurchase market in a crisis by providing a safe haven for lenders, as the Fed did in 2007-2008 but without its chaotic improvisation, writes reporter Cardiff Garcia at the Financial Times' Alphaville blog. July 27.
*****
Corporate treasurers with cash to invest should realize that "repo is simply a straightforward securitised deposit," Clearstream told Treasury Insider. July 21.
*****
Eight U.S. global systemically important bank holding companies will have to put more of their own money at risk if they want to rely on short-term wholesale funding like repos, because during the crisis "reliance on this type of funding left firms vulnerable to runs and fire sales," said the Federal Reserve. July 20.
*****
Barney Frank, one of the authors of Dodd-Frank, told the Wall Street Journal, "Look, I was never a total expert in this, [but] there is an argument from some that the triparty repo market [where large institutions get funding for their trading businesses] has not been fully regulated. If I were in Congress today I’d be looking to have hearings and learn about that and it may be that that needs to be better regulated." July 19.
*****
With the growing demand from lenders to make repo loans, and the declining interest from borrowers like banks and broker-dealers, the most likely borrower to fill the gap is the Federal Reserve, write Tracy Alloway and Liz McCormick at Bloomberg Business. June 29.
*****
In its annual report, the Bank for International Settlements worries that asset managers like hedge funds are picking up the business that banks are abandoning and in so doing may be creating unstable markets. June 28.

Search RepoWatch

Search for:

Follow Blog

Enter your email address to follow this blog and receive notifications of new posts by email.